SCOW: Cell Phone Termination Penalties Are Not Penalties

I suspect that most of you have signed up for a one- or two-year service plan with a cell phone company. And I suspect that as part of that agreement, you agreed to pay some sort of early termination fee (“ETF”) if you terminated the contract prior to the expiration of the agreed-upon term. In Minnick v. Clearwire US LLC (Wash., May 3, 2012), the Supreme Court was tasked (by certified question from the Ninth Circuit) with deciding whether that ETF provision is an alternative performance provision (“APP”) or a liquidated damages provision (“LDP”). Why is this important? Well, LDPs are subject to a “penalty” analysis to determine whether they are enforceable, while APPs are not subject to any such review.

Here, the Supreme Court concluded that Clearwire’s ETF was an APP because (1) customers had a “real option” at the time of contracting and (2) the option was of “relatively equal value” when compared to the alternative of fulfilling the rest of the service contract.

Like most wireless companies, Clearwire offered customers a choice between a month-to-month service contract and a one- or two-year service contract. The monthly contract offered greater flexibility, since the customer could cancel at the end of any month, while the longer-term contracts offered a lower monthly fee. The longer-term contracts, however, also offered the customers the option of terminating the contract early, provided that the customer paid the ETF.

The various plaintiffs in this case signed different contracts with different ETFs — some ETFs were fixed, while others were set at an initial dollar amount which was reduced month-by-month over the life of the contract. Generally, however, the ETF was less than the remaining payments on the contract, unless the termination occurred in the last few months of the contract, in which case it might be more than the remaining payments.

Apparently, Washington case law on ETFs is sparse. But there are some general standards to determine whether a contract provision is an APP or an LDP. Under Washington law, an APP requires a party to “render one of two or more alternative performances,” whereas an LDP “is a sum of money agreed upon in advance that is a reasonable forecast of just compensation for the harm caused by the breach.” (Note: that’s what an enforceable LDP is; if the LDP is not a reasonable forecast of just compensation, it’s still an LDP, it’s just invalid!)

The main fact, as expressed by the Supreme Court, is whether “the parties intended the options to give the promisor a real choice between reasonably equivalent choices.” In other words, are both alternatives real options, or is one of the options just a “device to assure the performance of the other option.” If the latter, then the provision is an LDP.

Applying those standards, the Court held that Clearwire’s ETF was an APP and therefore not subject to any kind of heightened “penalty” analysis. First, the Court concluded that the ETF provided a “real option” to customers because, at the time of contract, customers wouldn’t know whether they’d want to stick with the entire one- or two-year term, or whether they’d want to pay the ETF and get out early. The customers chose the lower monthly fees in exchange for the longer obligation, but retained the ability to get out by paying the ETF. According to the Court, that constituted a “real option.”

Second, the Court concluded that the options represented a “reasonable equivalence.”  Why? Because based on the “relative value of the options at the time of contracting” the ETF is generally significantly less than the remaining payments under the contract. So that’s enough.

Justice Chambers dissented. His dissent made various points, relying on Corbin, Williston, and the Restatement, all of which boil down to one of my favorite legal arguments: Really? Come on; this is a liquidated damages provision. It’s a persuasive argument. He noted that the ETF applies not only when the customer “chooses” to terminate the contract, but also if the customer breaches the contract. Such provisions — that apply in the case of breach — are classic LDPs. But most convincingly, Judge Chambers noted that cases of alternative performance involve just that — performance! Such performance by the customer would generally be accompanied by performance by the company. In other words, a true APP would provide that the customer may either (1) pay money or (2) give monthly back rubs, but either act would constitute performance and entitle the customer to the company’s performance — that is, the provision of wireless services. But this ETF is nothing like that. The customer’s alternative “performance” entitles the customer to… well… nothing.  (Although you could certainly say that the customer is therefore entitled to be free from the obligation of future monthly payments, but I just think that sounds a lot more like liquidated damages, not performance.)

A few additional thoughts: It seems like the Court wants to call the EFT an APP instead of an LDP because it thinks the ETF is reasonable and good and all that stuff. But the ETF could be fine as an LDP as well! There’s nothing disparaging about calling the ETF a perfectly reasonable LDP.

Also, I thought it interesting that the applicable analysis takes no account of the costs or benefits to the company — or the company’s performance at all. The Court’s opinion focused entirely on a comparison between (a) what the customer pays under the payment provisions of the contract and (b) what the customer pays under the ETF. There was no discussion of (1) what the customer receives under either scenario, (2) the value of what the customer receives, or (3) the costs the company saves by escaping the obligation of providing services for the term of the contract. Those seem like things that might matter in determining whether we’re talking about performance or a penalty.

Another consideration: This case is basically about a zero marginal cost good (wireless service). If the customer just breached the contract, disclaimed the service, and declined future payments, without the ETF the company would likely be able to recover the remainder of the contract payments. There would be no need to “cover” or find a “substitute” customer or anything like that, because the company can always take on extra customers. I wonder if the Court’s APP/LDP analysis would have been the same if, instead of wireless service, we were talking about a more limited quantity good — like a monthly membership to a coop that is at capacity, or something like that. If the company were able to cover a termination with another customer, meaning basically it would suffer no actual losses from a termination of the contract, that would make the ETF look a lot more like an LDP. But the Court’s opinion doesn’t seem to leave any room for that distinction.


One thought on “SCOW: Cell Phone Termination Penalties Are Not Penalties

  1. Pingback: [Tuesday] Monday [Afternoon] Morning Mash-up: May 15, 2012 | Ziff Blog

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